Predicting Time-Varying Value Premium Using the Implied Cost of Capital

We estimate an implied value premium (IVP) using the implied cost of capital methodology. The implied value premium is the difference between the implied costs of capital of value stocks and growth stocks and is a direct estimate of the difference in expected returns between value stocks and growth stocks. We find that IVP is the best predictor of ex-post value premium during the 1977-2012 time period at horizons ranging from one month to 36 months in univariate and multivariate forecasting regression tests. At the 12-month horizon, IVP is able to explain 18% to 29% of the variation in the ex-post value premium. Other forecasting variables such as value spread, default spread, term spread, and consumption-to-wealth ratio do not fare as well. IVP strongly predicts the difference in cumulative abnormal returns around future quarterly earnings announcements of value and growth stocks, and its predictive power is stronger during periods of extreme mispricing. IVP is unable to predict future macroeconomic activity. Overall our results are supportive of mispricing as at least a partial explanation for the predictable time variation in value premium